Keep a close eye on your subsidiary, says Court of Appeal

They can run away from parent companies

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A parent company can inadvertently lose control of its subsidiary, according to a ruling by the Court of Appeal. An expert has said that the circumstances in which this will happen are rare but that directors of group companies should mitigate the risks.

The ruling concerned the use by one company of its shareholding in another as the security on a loan. The effect of the ruling is that the status of some companies could be changed without directors' intent, according to a lawyer. It could also result in deliberate manipulations of corporate structures.

"The decision has caused consternation as there are many undesirable consequences of a company inadvertently ceasing to be a subsidiary of another company," said corporate law expert Justine Howard of Pinsent Masons, the law firm behind OUT-LAW.COM.

"It might cause the company to cease to be a member of a VAT group; it may trigger a change of control clause in an important commercial contract; or it may result in employees ceasing to be eligible to participate in employee share plans."

Howard said that the change in status could also allow companies to evade controls put in place by the Companies Act that govern how subsidiaries and holding companies interact, measures which are designed to protect shareholders, but she said that was less likely.

"Deliberate manipulation of a structure in this way may have other consequences," said Howard. "It could be a breach of duty, or even fraudulent, which would give shareholders a right of action."

But Howard warned that inadvertent loss of control was a realistic risk.

"Even the best-run companies could find that they have lost a subsidiary by not realising that a particular type of security document has changed its status, which could have serious consequences for the business as a whole," she said.

The case centred on a fire on a boat. Asco UK chartered a ship from Farstad in a deal which contained an indemnity for Asco and its affiliates. Asco was owned by a parent company, Asco plc. The ship's oil tanks were cleaned by another company owned by Asco plc, Enviroco.

There was a fire during that cleaning process which caused the death of one Enviroco employee and damage to the ship.

Enviroco claimed that it was covered by the indemnity, that it was an affiliate of Asco UK because, like it, it was a subsidiary of Asco plc.

However, Enviroco was not a wholly-owned subsidiary of Asco plc, which owned only 50% of Enviroco's shares. It was still classed as a subsidiary under the definition in the Companies Act, but only until the shares were pledged to the Bank of Scotland as security on a loan. That pledge was governed by Scots law, which required the shares to be registered in the name of the bank. At that point, Asco plc ceased to be a member of Enviroco and therefore Enviroco was no longer a subsidiary of Asco plc, the Court of Appeal ruled.

Howard said that companies will rarely find themselves unexpectedly and inadvertently no longer subsidiaries of parent firms. "The facts of this case are unusual," she said. "Asco held only 50% of the shares in Enviroco and once they'd been pledged, the company was outside the definition of subsidiary contained in the Companies Act."

"Most parent companies hold the majority of shares in their subsidiaries and most subsidiaries will fit within more than one of the limbs of the definition of subsidiary contained in the Act [unlike Enviroco]," said Howard. "Also, it's very unusual for shares to be transferred into the name of the bank or its nominee, especially under English law. Nevertheless, the consequences could be serious for any company finding itself in this situation."

A lower court had said that as a matter of "commercial reality and business sense" Enviroco should have been considered a subsidiary of Asco plc, but the Court of Appeal overturned that ruling. Enviroco has asked for permission to appeal the ruling.

Howard said that when a parent company uses shares in a subsidiary as security, and where the shares will be registered in the name of the bank providing the loan, or its nominee, the risk of losing subsidiary status can be avoided. She said that when giving security companies should:

* check whether security is being taken over shares carrying more than 50% of the voting rights;

* check that the security document allows the rights in respect of the shares to be exercised on the instructions of, or in the interests of, the parent company; and

* consider whether to use a wider definition of "subsidiary undertaking" in commercial agreements.